1. Intercompany Profit Transactions – Inventories
Chapter 5

2. Understand the impact of intercompany profit for
Learning Objective 1
Understand the impact of
intercompany profit for
inventories on preparation
of consolidation working papers.

3. Intercompany Inventory Transactions
Revenue Recognition
Revenue on sales between affiliated companies
cannot be recognized until merchandise is sold
outside of the consolidated entity.

4. Intercompany Inventory Transactions
Purchasing Agent
Periodic
inventory
system
Sales
Purchases
Perpetual
inventory
system
Sales
Cost of goods sold

5. Elimination of Intercompany Purchases and Sales
Pint formed a subsidiary, Shep Corporation.
All Shep’s purchases are made from
Pint at 20% above Pint’s cost.
Pint sold $20,000 of merchandise
to Shep for $24,000.
Shep sold all the merchandise
to its customers for $30,000.

6. Elimination of Intercompany Purchases and Sales
Pint’s Books
Inventory ,000
Accounts Payable ,000
To record purchases on account from other entities
Accounts Receivable 24,000
Sales ,000
To record intercompany sales to Shep

7. Elimination of Intercompany Purchases and Sales
Pint’s Books
Cost of Sales 20,000
Inventory ,000
To record cost of sales to Shep
Investment ,000
Income from Shep ,000
To record related equity interest

8. Elimination of Intercompany Purchases and Sales
Shep’s Books
Inventory ,000
Accounts Payable ,000
To record intercompany purchases from Pint
Accounts Receivable 30,000
Sales ,000
To record sales to outside customers

9. Elimination of Intercompany Purchases and Sales
Shep’s Books
Cost of Sales 24,000
Inventory ,000
To record cost of sales to customers

10. Elimination of Intercompany Purchases and Sales
100% Adjustments and Consol-
Pint Shep Eliminations idated
Sales
Cost of sales
Gross profit
$24,000
20,000
$ 4,000
$30,000
24,000
$ 6,000
a 24,000
$30,000
20,000
$10,000

11. Elimination of Unrealized Profit in Ending Inventory
During 2004, Pint sold merchandise that
cost $30,000 to Shep for $36,000.
Shep sold all but $6,000 of this
merchandise to its customers for $37,500.

12. Elimination of Unrealized Profit in Ending Inventory
30,000 ÷ 36,000 = 5/6
5/6 × 30,000 = $25,000
1/6 × 36,000 = $6,000
1/6 × 30,000 = $5,000
Shep’s inventory $6,000
Cost to Pint –5,000
Unrealized profit in EI $1,000

13. Elimination of Unrealized Profit in Ending Inventory
Adjustments and Consol-
Pint Shep Eliminations idated
Sales
Cost of sales
Gross profit
Inventory
$36,000
30,000
$ 6,000
$37,500
30,000
$ 7,500
$ 6,000
a 36,000
b 1,000 a 36,000
b 1,000
$37,500
25,000
$12,500
$ 5,000

14. Recognition of Unrealized Profit in Beginning Inventory
During 2005 Pint sold merchandise
that cost $40,000 to Shep for $48,000.
Shep sold 75% of this merchandise
to its customers for $45,000.
Shep also sold its beginning inventory
with a transfer price of $6,000 for $7,500.

15. Recognition of Unrealized Profit in Beginning Inventory
25% × 48,000 = $12,000 Ending inventory
$12,000 ÷ 1.2 = $10,000 EI transfer price
Shep’s inventory $12,000
Cost to Pint (10,000)
Unrealized profit in EI $ 2,000

16. Recognition of Unrealized Profit in Beginning Inventory
$7,500 – $5,000 BI = $2,500 from BI
75% × 48,000 = $30,000
$45,000 – $30,000 = $15,000
$15,000 + $2,500 = $17,500

17. Recognition of Unrealized Profit in Beginning Inventory
Adjustments and Consol-
Pint Shep Eliminations idated
Sales
Cost of sales
Gross profit
Inventory
Investment
in Shep
$48,000
40,000
$ 8,000
XXX
$52,500
42,000
$10,500
$12,000
a 48,000
c 2,000 a 48,000
b 1,000
c 2,000
b 1,000
$52,500
35,000
$17,500
$10,000

18. upstream versus downstream
Learning Objective 2
Apply the concepts of
upstream versus downstream
inventory transfers.

19. Downstream and Upstream Sales
Sales from top
to bottom are
downstream.
Sales from
bottom to top
are upstream.
Parent to
Subsidiary
Subsidiary to
Parent

20. Downstream and Upstream Sales
In downstream sales, the parent company’s
separate income includes the full amount of
any unrealized profit, and the subsidiary’s
income is not affected.
In upstream sales, the subsidiary company’s
net income includes the full amount of any
unrealized profit, and the parent company’s
separate income is not affected.

21. Downstream and Upstream Effects on Income Computations
80%-owned
Parent Subsidiary
Sales $ $300
Cost of sales
Gross profit $ $120
Expenses
Parent’s separate income $200
Subsidiary’s net income $ 50

22. Downstream and Upstream Effects on Income Computations
Intercompany sales during the year are $100,000.
The December 31 inventory includes
$20,000 unrealized profit.

23. Downstream and Upstream Effects on Income Computations
The parent company’s
sales and cost of sales
accounts reflect the
$20,000 unrealized profit.
The $50,000
subsidiary net
income equals its
realized income.

24. Downstream and Upstream Effects on Income Computations
The subsidiary’s sales and
cost of sales accounts reflect
the $20,000 unrealized profit.
The subsidiary’s
realized income
is $30,000.

25. Downstream and Upstream Effects on Income Computations
Consolidated Income (000) Downstream Upstream
Sales ($900 – $100) $800 $800
Cost of sales ($480 + $20 – $100)
Gross profit $400 $400
Expenses ($100 + $70)
Total realized income $230 $230
Less: Minority interest
Consolidated net income $220 $224

26. Downstream and Upstream Effects on Income Computations
Consolidated Income (000) Downstream Upstream
Parent’s separate income $200 $200
Add: Income from subsidiary:
Equity in subsidiary’s income
less unrealized profit
[($50,000 × 80%) – $20,000]
[($50,000 – $20,000) × 80%]
Parent and consolidated net income $220 $224

27. Defer unrealized inventory profits remaining in ending inventory of
Learning Objective 3
Defer unrealized inventory profits
remaining in ending inventory of
either the parent or subsidiary.

28. Deferral of Intercompany Profit in Period of Sale: Downstream
90%-owned
Porter Sorter
Sales $ $50
Cost of sales
Gross profit $ $15
Expenses
Operating income $ $10
Income from Sorter –
Net income $ $10

29. Deferral of Intercompany Profit in Period of Sale: Downstream
Porter’s sales include $15,000 to Sorter
at a profit of $6,250.
Sorter’s December 31, 2003, inventory includes
40% of the merchandise from this transaction.

30. Deferral of Intercompany Profit in Period of Sale: Downstream
$15,000 – $6,250 = $8,750
Cost
$8,750 × 40% = $3,500
$15,000 × 40% = $6,000
Unrealized profit
$6,000 – $3,500 = $2,500

31. Deferral of Intercompany Profit in Period of Sale: Downstream
Porter’s Books
Investment in Sorter 9,000
Income from Sorter ,000
To record share of Sorter’s income
Income from Sorter 2,500
Investment in Sorter ,500
To eliminate unrealized profit on sales to Sorter

32. Partial Working Papers December 31, 2003
Adjustments/ Consol-
Porter Shorter Eliminations idated
Income Statement
Sales
Income from Sorter
Cost of goods sold
Expenses
Minority interest expense
($10,000 × 10%)
Net income
Balance Sheet
Inventory
Investment in Sorter
$100
6.5
(60)
(15)
$ 31.5
XXX
$50
(35)
(5)
$10
$ 7.5
Dr. Cr.
a 15
c 6.5
b a 15
b 2.5
c 6.5
$135
(82.5)
(20)
(1)
$ 31.5
$ 5

33. Recognize realized, previously deferred inventory profits in
Learning Objective 4
Recognize realized, previously
deferred inventory profits in
the beginning inventory of
either the parent or subsidiary.

34. Recognition of Intercompany Profit upon Sale to Outside Entities
Now assume that the merchandise acquired from
Porter during 2003 is sold by Sorter during 2004.
There are no intercompany transactions
between Porter and Sorter during 2004.

35. Recognition of Intercompany Profit upon Sale to Outside Entities
90%-owned
Porter Sorter
Sales $ $60
Cost of sales
Gross profit $ $20
Expenses
Operating income $ $15
Income from Sorter –
Net income $ $15
This is before considering $2,500 unrealized profit in BI.

36. Recognition of Intercompany Profit upon Sale to Outside Entities
Porter’s Books
Investment in Sorter ,500
Income from Sorter ,500
To record investment income from Sorter
Investment in Sorter ,500
Income from Sorter ,500
To record realization of profit from
intercompany sales to Sorter

37. Partial Working Papers December 31, 2003
Adjustments/ Consol-
Porter Shorter Eliminations idated
Income Statement
Sales
Income from Sorter
Cost of goods sold
Expenses
Minority interest expense
($15,000 × 10%)
Net income
Balance Sheet
Investment in Sorter
$120 16
(80)
(20)
$ 36
XXX
$60
(40)
(5)
$15
Dr. Cr.
b 16
a 2.5
a 2.5 b 16
$180
(117.5)
(25)
(1.5)
$ 36

38. Adjust the calculations of minority interest amounts in the presence
Learning Objective 5
Adjust the calculations of minority
interest amounts in the presence
of intercompany inventory profits.

39. Consolidation Example – Intercompany Profits: Downstream Sales
Seay Corporation is a 90%-owned
subsidiary of Peak Corporation,
acquired for $94,500 cash on July 1, 2003.
Seay’s net assets at date of acquisition
consisted of $100,000 capital stock
and $5,000 retained earnings.
The cost of Peak’s 90% interest was equal to book
value and fair value of the interest acquired.

40. Consolidation Example – Intercompany Profits: Downstream Sales
July 1, 2003
Cost: $105,000 × 90% = $94,500
Minority interest: $105,000 × 10% = $10,500

41. Consolidation Example – Intercompany Profits: Downstream Sales
Peak sells inventory items to Seay on a regular basis.
Sales to S in 2007 (cost $15,000), selling price $20,000
Unrealized profit in S’s inventory at 12/31/ ,000
Unrealized profit in S’s inventory at 12/31/ ,500
Seay’s accounts payable to Peak 12/31/ ,000

42. Consolidation Example – Intercompany Profits: Downstream Sales
At 12/31/2006 Peak’s investment in Seay
account had a balance of $128,500.
This balance consisted of Peak’s 90%
equity in Seay’s $145,000 net assets on
that date less $2,000 unrealized profit
in Seay’s 12/31/2006 inventory.

43. Consolidation Example – Intercompany Profits: Downstream Sales
December 31, 2006
$145,000 × 90% = $130,500
$130,500 – $2,000 = $128,500

44. Consolidation Example – Intercompany Profits: Downstream Sales
December 31, 2006
Seay’s equity:
Common stock $100,000
Retained earnings ,000
Net assets $145,000
$45,000 – $5,000 = $40,000 increase in RE
$40,000 – $4,000 (minority interest) = $36,000

45. Consolidation Example – Intercompany Profits: Downstream Sales
During 2007, Peak made the following entries
on its books for the investment in Seay:
Cash ,000
Investment in Seay ,000
To record dividends from Seay ($10,000 × 90%)
Investment in Seay 26,500
Income from Seay ,500
To record income from Seay for 2007

46. Consolidation Example – Intercompany Profits: Downstream Sales
December 31, 2007
Equity in Seay’s net income: ($30,000 × 90%) $27,000
Add: Inventory profits recognized in ,000
Deduct: Inventory profits deferred at year end – 2,500
Total $26,500

47. Consolidation Example – Intercompany Profits: Downstream Sales
Peak’s Investment
94,500
36,000
128,500
2,000
27,000
146,000
2,000
2,500
9,000
12/31/2006
Dividends
12/31/2007

48. Consolidation Example – Intercompany Profits: Downstream Sales
Minority Interest
1,000
10,500
4,000
14,500
3,000
16,500
12/31/2006
Dividends
12/31/2007

49. Consolidation Example – Intercompany Profits: Upstream Sales
Smith Corporation is an 80%-owned subsidiary
of Poch Corporation, acquired for $480,000
cash on January 2, 2003.
Smith’s stockholders’ equity consisted of
$500,000 capital stock and $100,000
retained earnings.
The cost of Poch’s 80% interest was equal to
book value and fair value of the interest acquired.

50. Consolidation Example – Intercompany Profits: Upstream Sales
Smith sells inventory items to Poch on a regular basis.
Sales to P in $300,000
Unrealized profit in P’s inventory at 12/31/ ,000
Unrealized profit in P’s inventory at 12/31/ ,000
Intercompany A/R and A/P at 12/31/ ,000

51. Consolidation Example – Intercompany Profits: Upstream Sales
At December 31, 2003, Poch’s investment in
Smith had an account balance of $568,000.
This balance consisted of $600,000 underlying
equity in Smith’s net assets ($750,000 × 80%)
less $32,000 unrealized profit in Poch’s
December 31, 2003, inventory.

52. Consolidation Example – Intercompany Profits: Upstream Sales
During 2004, Poch made the following entries
on its books for the investment in Smith.
Cash ,000
Investment in Smith ,000
To record dividends from Smith ($50,000 × 80%)
Investment in Smith 88,000
Income from Smith ,000
To record income from Smith for 2004

53. Consolidation Example – Intercompany Profits: Upstream Sales
December 31, 2004
Equity in Smith’s net income ($100,000 × 80%) $80,000
Add: 80% of $40,000 unrealized profit
deferred in ,000
Less: 80% of $30,000 unrealized profit
at December 31, –24,000
Total $88,000

54. Consolidation Example – Intercompany Profits: Upstream Sales
Poch’s Investment
480,000
Income
568,000
32,000
80,000
616,000
32,000
40,000
24,000
12/31/2003
Dividends
12/31/2004

55. End of Chapter 5